Overconfidence, Compensation Contracts, and Capital Budgeting

ABSTRACT

A risk‐averse manager’s overconfidence makes him less conservative. As a result, it is cheaper for firms to motivate him to
pursue valuable risky projects. When compensation endogenously adjusts to reflect outside opportunities, moderate levels of
overconfidence lead firms to offer the manager flatter compensation contracts that make him better off. Overconfident managers
are also more attractive to firms than their rational counterparts because overconfidence commits them to exert effort to
learn about projects. Still, too much overconfidence is detrimental to the manager since it leads him to accept highly convex
compensation contracts that expose him to excessive risk.